The news is in the misbehaviour of financial markets

Markets have a personality, according to Mandelbrot’s third rule. Investors, traders, lawyers, bankers and speculators usually meet to discuss these issues

 

By Colls Ndlovu

 

As has become a ritualistic routine now, the bulk of the arguments in today’s article are already covered in my book entitled “Bonds and the Bond Markets”(pictured below).

On 2 August 2020, the price of the Bitcoin currency crashed dramatically from US$12 000 per coin, down to about US$11 400 implying a potential loss of about US$1600 on the basis of a mark-to-market valuation.

Orthodox financial theory argues that variation in prices can be modeled by random processes. The volatility of stock market prices is deemed to be determined by randomness depending on the availability of information. Information has a bearing on the supposed efficiency of the market.

Prof. Harry Markowitz, formerly of the University of Chicago is the father of this efficient markets hypothesis.

Other academics argue that prices in reality misbehave and do not follow the Markowitzan efficient markets hypothesis. Prof Benoit Mandelbrot, formerly of Yale University argues for a multifractal model of wild price variations which he advances as an alternative financial theory. According to Mandelbrot, the markets are basically driven by five rules.

The first rule is that markets are risky. Price movements do not follow the conventional bell curve which is assumed to be the normal behaviour by the establishment. Prices follow more violent and volatile swings. An appreciation of this fact is very useful. This absurd behaviour is described by John Maynard Keynes as the animal spirits of the market.

The irrational exuberance of the markets

Former US Federal Reserve Chairman, Alan Greenspan, famously referred to it as the irrational exuberance of the markets, that is to say, the herd-like behaviour of the markets.

The second rule is that market turbulence tends to cluster. Turbulence, especially for the banking industry usually takes a systemic route and if not checked or curtailed, could destabilise and disrupt the whole financial system leading to a contagion that can ricochet across the whole system as was seen during the global financial markets crisis of 2008.

Markets have a personality, according to Mandelbrot’s third rule. Investors, traders, lawyers, bankers and speculators usually meet to discuss these issues. When that happens, a new variable or dynamic emerges which has legs of its own and is not the same as the individual parts that constituted it.

Prices are determined by the internal endogenous processes of the market itself rather than merely exogenous factors.

The other variable says that markets mislead. Markets create fictitious patterns and pseudocycles that can lull an unassuming investor into a false sense of security. This happens through the appearance of somewhat predictive graphs and patterns that appear to predict the future and thus bankable. A financial market is vulnerable to such statistical illusions. Chartists therefore tend to be easily fooled by bubbles and crashes which are inherent in capitalistic markets.

Markets slow down significantly during episodes of tranquility

Markets’ time is relative, according to the fifth rule. The rationale being that markets’ time tends to be Einsteinan. Markets are perceived to move very fast during periods of extreme volatility, and to slow down significantly during episodes of tranquility. Legend has it that all charts look alike whether they are for 10 minutes, 10 hours, 10 days and 10 years.

What will distinguish them are the legends on the foot of the graph or chart.

Much as the markets are scenes where great wealth can be made, they are also a scene where severe losses can be incurred. Consequently, the maxim is that greater knowledge of a danger permits greater safety.

In general the key assumptions underpinning the efficient markets hypothesis are somewhat wobbly.

Admittedly, models by their very nature tend to distort reality. As they say, the map is not the territory. In financial models, economists make certain assumptions which sometimes beggars belief.

In particular the assumption that people are rational and always aim to maximize their returns is not grounded on reality. The allegation that individuals once presented with all relevant market information will act rationally is not correct.

The reality is that people do not think in a mechanical or linear fashion like some theoretical utility measurable in dollars and cents. People are not always rational and self-interested.

Sometimes they are irrational and philanthropic. Sometimes people misinterpret information and allow their emotions to get the better of them.

It is inaccurate to say that all investors are homogenous

The other fallacy is that all investors are the same. The assumption that investors when given the same information will use it exactly the same, at the same time and at similar intervals or frequencies in not grounded on reality.

It is inaccurate to say that all investors are homogenous and are like molecules that are a replica of each other always in a constant Brownian motion with very minimal negligible differences between them.

The fact of the matter is that people are different and their appetites differ. Some are long term investors. Others are short-term investors. Some are speculators. Others do not even invest at all. Fundamentalist investors believe that each stock or currency has its own intrinsic value and therefore will eventually self-correct and sell for that value.

Chartists ignore the fundamentals and follow the trends on graphs jumping on and off the band wagon. Markets behave in non-linear and linear functions and sometimes in a combination of the two thus breeding a third unique behaviour.

The other market assumption is that price changes are stochastic and continuous. The change is assumed to smooth and controlled moving from one value to another in a predictable fashion.

Through his efficient markets hypothesis, Markowitz sought to reduce investment decision into two variables: mean and variance of expected prices, effectively, some mathematical proxies for risk and return.

In reality prices do swing both trivially and wildly. Prices do not follow a stochastic smooth pattern.

Furthermore, prices are assumed to be following the Brownian motion (movement of molecules in physics). This assumption is accompanied by the suggestion that such price changes are independent, constant and therefore follow a normal bell curve distribution. The reality of course is that real life situations are more complex than these assumptions.

The hard reality on the ground tends to contradict these assumptions especially the much-paraded bell curve normal distribution.

 

Colls Ndlovu, a currency expert, is an award-winning economist and central banker, and is the inventor of the NCX Currency Index. He can be contacted on collsndlovu@gmail.com

 

 

 

 

History made as the Ndlovu Currency Confidence Index (NCX) on the Zim$ debuts at 38%

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